In the first part of this mini-series on retirement financial planning, we looked at how much you need to save for retirement. Along with the newfound freedom of hitting this number and leaving your career comes the responsibility of managing this nest egg to ensure a comfortable and sustainable lifestyle. Central to this is understanding the concept of the ‘safe withdrawal rate’ to make your saving last through your golden years.
What is the safe withdrawal rate?
This refers to the percentage of your retirement savings that can be taken out to fund your day-to-day life each year without significantly depleting the principal balance over the rest of your retirement. So what is this magic percentage? That’s a bit individualized, and has become more debatable in recent years.
Historically, the ‘4% Rule’ has been cited for a safe withdrawal rate. In other words, a retiree can withdraw 4% of their initial retirement portfolio balance if the first year, then adjust the subsequent withdrawals for inflation each year thereafter. For example, for every $1 million saved for retirement, you could spend $40,000 (before tax) in the first year. In the second year, if inflation was 2%, you could take out $40,000 x 1.02 = $40,800.
This widely quoted rule comes from financial advisor William Bengen’s 1994 paper that suggested that most retirement portfolios would last at least 30 years1. This concept caught on quickly since it’s easy to understand. However, you have to look at the underlying assumptions to see if it still applies today.
What factors influence the safe withdrawal rate?
Portfolio allocation: A good investment portfolio has wide diversification, some more aggressive (can expect wider swings in returns or losses) like stocks, and some more conservative (expect smaller gains, but also smaller potential losses) like bonds. When people are younger, they can afford to have a higher risk tolerance (i.e. more stocks), since they have more ‘runway’ to make up for losses during their working years. Many experts recommend a blend of 80% stocks and 20% conservative investments like bonds or fixed income early in your career. Approaching retirement, the percentage of stocks tends to drop to reduce the risk of something catastrophic happening to your nest egg. In Bengen’s paper, he assumed a portfolio of 50% stocks and 50% bonds. This ratio allowed portfolios to withstand a 4% withdrawal rate for 35 years, but some ran out of money in a projected 50-year retirement. Re-doing the math now, it looks like the 4% rule requires a stock allocation of between 50% and 75%2.
Market allocation: No one can predict the future performance of the stock market. Imagine retiring right before the Great Depression; stocks were down 61% between 1929 and 19312. The good news is that Bergen’s study showed that even in this terrible set of circumstances, retirees had their portfolios survive more than 30 years following the 4% withdrawal rule1.
Longevity: Bengen’s paper used calculations based on a planned 30-year retirement. Early retirement and/or a long-life expectancy means that a safe withdrawal rate that covers 40 to 50 years may make more sense for you.
Inflation: You would think that retiring between 1929 and 1931 would be the absolute worst-case scenario. Not true: retiring right before 1973 was even worse (in America, at least). Between 1973 and 1974 prices rose by 22% with inflation; retirees had to increase their annual withdrawals just to keep that same standard of living2.
Withdrawal flexibility: Retirees should remain flexible with their withdrawal strategies based on market volatility and unexpected personal expenses. The 4% rule assumes a rigid draw down rate; you may want to reduce your withdrawal in a bear market or times of high inflation to increase your portfolio’s longevity2.
Fees: Bengen’s original publication did not take into account management fees, that can erode your return on investment. Be mindful of actively managed portfolios with high fees.
Is the 4% rule still valid?
With all these factors that should be individualized, the question becomes, is the 4% withdrawal rate still useful in 2024? You could argue that the rule has already withstood epic bear markets and global tragedies like World War II. However, I think that a withdrawal rate below 4% makes sense for a lot of us. More recent studies (including non-American sources) support this concept, suggesting withdrawal rates closer to 3%3. The safe withdrawal rate should be constantly updated based on market conditions and the inflation rate, and indeed Morningstar has been publishing a new rate annually since 20214. The safe withdrawal rate based on their calculations have increased from 3.3% in 2021 to 3.8% in 2022 to the most recent rate of 4% at the end of 20235. In the end, I like to use a conservative 3% in my projections to be able to sleep better at night knowing that my retirement nest egg is well protected.
Author: Dr. Krishna Sharma, Director of Physician Engagement, Specialty Medical Partners
References:
Bengen WP. Determining withdrawal rates using historical data. Journal of Financial Planning 1994 Oct 1;7(4):171-80.
Berger R and Curry B. “What is the 4% rule for retirement withdrawals?” Forbes Advisor Feb 19, 2023. https://www.forbes.com/advisor/retirement/four-percent-rule-retirement/
Anarkulova A, Cederburg S, O’Doherty MS, et al. The safe withdrawal rate: evidence from a broad sample of developed markets. July 18, 2023. Available at SSRN: https://ssrn.com/abstract=4227132
Benz C. “Retirement income and safe withdrawal rates in 2023” Morningstar Jan 18, 2023. https://www.morningstar.com/retirement/retirement-income-safe-withdrawal-rates-2023
Arnott, A. “The good news on safe withdrawal rates” Morningstar Nov 13, 2023. https://www.morningstar.com/retirement/good-news-safe-withdrawal-rates
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